Finance fundamentals for nonprofits

Finance fundamentals for nonprofits

Copyright # 2011 by Woods Bowman All rights reserved.

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Library of Congress Cataloging-in-Publication Data:

Bowman, Woods, 1941–

Finance fundamentals for nonprofits: building capacity and sustainability/

Woods Bowman.

p cm — (Wiley nonprofit authority)

Includes bibliographical references and index.

ISBN 978-1-118-00451-7 (hardback); 978-1-118-11398-1 (ebk); 978-1-118-11400-1 (ebk); 978-1-118-11399-8 (ebk)

1 Nonprofit organizations—Finance 2 Nonprofit organizations—United States— Finance I Title.

To Michele

Advantages and Disadvantages of Being Nonprofit 8

CHAPTER 4 Budgeting: Taking Control of the Present 49

Reconciling Budgets and Financial Statements 55

CHAPTER 6 Ordinary Service Providers: Serving the Public Today 81

CHAPTER 7 Membership Associations: Serving People

Appendix: ASAE/CAL Metrics of Financial

CHAPTER 8 Endowed Service Providers: Serving

Long-Term Objective: Maintaining Services 111

Current Objective: Paying Bills 115

Appendix: S&P Metrics of Financial

CHAPTER 10 Beyond Sustainability: Managing Revenue

Chapters 6 through 10, which form the core of this book, provide eral formulas for goal-setting and diagnostic measurement of sustainability,and the companion concept of capacity I searched the literature for tried-and-true formulas familiar to practitioners, favoring formulas with the fewestvariables so their interrelationships would be transparent Nevertheless, Ihad to redefine a few variables in familiar formulas, and in some cases it wasnecessary to invent new formulas.

sev-One contribution of this book is showing how a variety of financial cepts, as described by these formulas, are interrelated and work together totell a coherent story To aid practitioners, the publisher’s web site hasspreadsheets that automatically calculate all of the formulas using only datafrom an IRS Form 990 informational return

con-ix

To illustrate concepts, nearly every chapter begins with a vignette of areal problem, which I analyze after the chapter lays the necessary ground-work Wherever my commentary seemed critical, I avoided using an organi-zation’s real name Organizations featured in published accounts are usuallyidentified The opening vignette of Chapter 10 uses actual names but thefinancial data are publicly available and it focuses on an organization whosestory is recounted by a book readily available in libraries The analysis parsesdecisions made generations ago that left a permanent mark on the organiza-tion; it does not reflect on the current leadership.

Practitioners who are most likely to find this book useful are successfulbusinesspersons on nonprofit boards trying, as I once did, to adapt whatthey know about business to a nonprofit organization Executive directorswho worked their way up through a series of service-delivery roles andwho have learned finance on the job may find it useful as a way to fill ingaps in their knowledge about the business of being nonprofit

I tried to translate business concepts into jargon-free language withoutsacrificing technical accuracy I retain terms like markup that are common inbusiness even if they sound strange in a nonprofit context I define all termsupon first use and provide a Glossary to help readers quickly summon a defi-nition when needed later When not discussing my own research, I make co-pious use of citations to recognize landmark contributions and to supportsubstantive statements with state-of-the-art research by experts Any recom-mendations are based on the weight of the best available evidence

Researchers may find this book’s systematic treatment of certain topicshelpful as a reference on matters where nonprofits and for-profits differ Itcould also be used as a text in nonprofit financial management, but instruc-tors might want to assign supplemental material on basic financial topics,such as cash flow analysis, that are common to both businesses and non-profits A particularly helpful feature for the classroom is how this bookcompares and contrasts different types of nonprofits: ordinary service pro-viders, endowed service providers, membership associations (includingcooperatives), and grantmakers

I would like this book to be readable and interesting as well as useful, so

I make extensive use of endnotes for technical details that are likely to be ofinterest only to specialists, and for color I scatter snippets of history hereand there

Woods BowmanChicago, IllinoisMarch 2011

I began this book in 2008 while lecturing at the Rotterdam School of agement of Erasmus University in the Netherlands I thank my host LucasMeijs and his faculty colleagues and staff of the Department of BusinessSociety Management for the invitation and their support

Man-In 2009 I taught a special topics course in the Kellstadt School of ness of DePaul University using the new materials, and for this opportunity

Busi-I thank Dean Ray Whittington of the School; Scott Young, chair of theManagement Department; and Pat Murphy, director of the School of PublicService, where I am a member of the faculty

I completed most of a first draft of the manuscript in 2010 while visiting

at the Department of Public Management and Policy of the Andrew YoungSchool of Policy Studies of Georgia State University in Atlanta I thank myhost Dennis Young and his faculty colleagues and staff for the invitation andtheir support

Readers will share my gratitude to the many experts—academic andpractitioner—who read portions of the manuscript, which improved thefinal product considerably: Grace Budrys, Chris Einolf, Bonnie Frankel,Michael Frigo, Deborah Gillespie, Andy Holman, Marc Jegers, DeniseNitterhouse, Michael O’Neill, George Rosen, Monroe Roth, Keith Skillman,Rob Taylor, and Dennis Young I cannot thank them enough I would like

to acknowledge persons affiliated with various pseudonymous tions used as illustrations, but it might compromise their organizations’anonymity I am grateful for their help nevertheless

organiza-I truly appreciate the work of my graduate assistants who labored overthe manuscript in its final stages: Mary Kate Murray of Georgia State Univer-sity and Liz Schering, Joan Pinnell, and Jose Rodriquez-Domingos of DePaulUniversity deserve considerable thanks for tirelessly reading and correctingthe manuscript

I want to acknowledge my students at DePaul University, Erasmus versity, and Georgia State University whose questions helped me refine my

Uni-xi

ideas I also owe a debt to practitioner participants in the many forumswhere I presented my preliminary work, including the Program for Non-profit Excellence in Memphis, the Helen Bader Institute Executive Work-shop in Milwaukee, and the Executive Leadership Program for NonprofitOrganizations in Georgia.

I hope that constant sifting and testing of ideas removed all errors, but Iknow better I bear full responsibility for the remaining ones When the timecame to publish, I sought advice from Peter Frumkin, Kirsten Grønbjerg, andHarvey Rosen, who were very helpful and they too have my thanks

cor-in common However, their rarity also cor-indicates fundamental differences.Finance Fundamentals for Nonprofits sheds light on similarities and dif-ferences between nonprofits and for-profit businesses It is intended to pro-vide a foundation in nonprofit finance for graduate students, assist nonprofitmanagers, and instruct corporate executives on nonprofit boards It does notdelve into finance techniques that are the same in nonprofit and for-profitbusinesses.

The book’s subtitle (Building Capacity and Sustainability) signals itsemphasis on two concepts of particular importance to nonprofits Whereasfor-profit managers are concerned with maximizing their firm’s marketvalue, nonprofit managers may have many financial goals.2Finance Funda-mentals for Nonprofits proposes that nonprofit managers should be primar-ily concerned with having the financial capacity their mission requires andsustaining it over time

1

Finance Fundamentals for Nonprofits: Building Capacity and Sustainability

by Woods BowmanCopyright © 2011 Woods Bowman

Financial capacity for a nonprofit consists of the resources necessary toseize opportunities and respond to threats.3The amount needed depends

on its mission, service delivery method, operating environment, and risks ofpotential adverse economic events Maintaining assets takes time, effort, andmoney, so managers choose a capacity level that balances the costs of main-taining capacity with its benefits

Financial sustainability is simply the rate of net change in financial pacity It is a clear-cut issue for most profit-maximizing businesses By max-imizing profit, assets grow as fast as possible and sustainability takes care ofitself However, sustainability is an issue for nonprofits that trade off sur-pluses (the profits of nonprofits) in favor of serving more people and serv-ing them better They must take care not to spend too much on such worthyobjectives because over the long run they must be able to keep their assets

ca-in good shape and maca-intaca-in their reserves at a level commensurate withanticipated economic risks A sustainability principle requires consistencybetween the short run (as measured by annual surpluses) and the long run(as measured by asset growth) This is the subject of Chapters 6 through 9

A major difference between nonprofit and for-profit financial ment is that many nonprofits generate income from sources other than sell-ing goods and services as for-profits do Such alternative income includesgifts, grants, dues, and income from endowments Even if a nonprofit has

manage-no sources of alternative income it can choose to develop them, which gives

it strategic options foreclosed to a for-profit firm

Financial models used by for-profit managers must be modified beforeapplying them to nonprofits, because alternative income reverses financiallogic In for-profit firms production creates revenue through sales; but innonprofits with alternative income the amount of income determines howmuch can be produced

This chapter introduces the book’s agenda, beginning with a discussion

of alternative definitions of nonprofit—or not-for-profit, as accountants callthem—attempting to discern the essential character of ‘‘nonprofitness.’’Then it describes the intrinsic similarities and differences between for-profitand nonprofit corporations, highlighting the advantages and disadvantages

of the nonprofit type

A few technical terms are necessary for this discussion Later chapters onrelated topics will define them In the meantime, readers may consult theGlossary at the end of the book to clarify unfamiliar terms

What Are Nonprofits?

The simplest and most common definition of a nonprofit organization is onethat is ‘‘barred from distributing its net earnings, if any, to individuals who

exercise control over it, such as members, officers, directors, or trustees’’(Hansmann 1980).4The prohibition on distributing net earnings to privateparties is widely known as the nondistribution constraint The principalshortcoming of this legalistic definition is that it makes no reference to non-economic values, which is the social justification for nonprofits The UnitedNations (UN) uses a more robust definition, which defines nonprofits as:organizations that do not exist primarily to generate profits, eitherdirectly or indirectly, and that are not primarily guided by commercialgoals and considerations [They] may accumulate surplus in a givenyear, but any such surplus must be plowed back into the basic mission

of the agency and not distributed to the organizations’ owners,members, founders or governing board (United Nations 2003, 18)This definition is not explicit about the noneconomic values because itmust apply in all countries despite their cultural differences FinanceFundamentals for Nonprofits uses the UN definition because it implies theprimacy of values In the United States, tax exemption laws address nondis-tribution through intermediate sanctions and keep nonprofits mission-focused by specifying acceptable exempt purposes (see Chapter 5)

For-profit firms may espouse social values, but these values usually aresecondary to maximizing a firm’s economic value or they are instrumentaltoward that end The Body Shop and Ben & Jerry’s are well-knownexamples of values-centered for-profit firms, but it is significant that theyearned their reputations before going public—meaning before selling stock

on a public exchange—and acquiring investor-owners

Social values are the business of nonprofits As Rose-Ackerman says,nonprofit customers ‘‘are buying reified ideology’’ (1997, 128) Nonprofitspractice values-centered management—a control regime in which social,cultural, and spiritual values join with economic necessity to define anorganization’s management objective.5The absence of owners seeking ahandsome return on their investment enables nonprofits to practice values-centered management

‘‘Cooperatives, mutuals [mutual benefit organizations], and self-helpgroups share some, if not most, of the defining features of a nonprofitorganization, and fall into a ‘grey area’ between the nonprofits and for-profitbusinesses In some countries they are considered legally to be nonprofits;

in others, not’’ (Anheier 2005, 52) The source of confusion is the fact thatthe purpose of a membership association, and especially cooperatives, is toconfer benefits on its members and patrons

Cooperatives strive to maximize economic benefits to their patrons,which may include an explicit distribution of annual surplus.6 However,cooperatives are typically committed to social goals of common interest to

the group In Francophone regions these organizations form a very tant cluster known as the Social Economy The UN standard is sufficientlybroad to include them, so Finance Fundamentals for Nonprofits treats mem-bership associations, including cooperatives, as if they were nonprofits.7

impor-Why Are There Nonprofits?

The standard economic paradigm explaining why nonprofits exist is based

on a three-sector structure of society consisting of market, government, andnonprofits Each sector serves to check excesses and compensate for theshortcomings of the other sectors.8

Weisbrod (1975) proposed that a bloc of people will always be fied with the amount of goods and services provided by government.Individuals who want more of a service will form a nonprofit organization

dissatis-to provide it with voluntary donations This is known as the governmentfailure model

Hansmann (1980) argued that nonprofits are needed as a response tosituations where consumers cannot easily compare products and prices,negotiate with a provider, or determine whether the provider complied with

an agreement and obtain redress if it did not In his view, a legal bution constraint solves the problem neatly This is known as the marketfailure or contract failure model The antiexploitive nature of the nondistri-bution constraint is intrinsically attractive to stakeholders, preventing themfrom shirking (Valentinov 2008)

nondistri-Salamon (1987) turned these explanations on their heads, arguing that it

is more reasonable to suppose that people initially organize to provide anew service voluntarily and then turn to government to finance expansion,

or even provide it directly, after the product was proven and demandestablished History is on his side: Voluntary fire brigades date to Romantimes, and libraries in the United States were initially organized as member-ship associations

However, nonprofits have limitations that are more easily overcome

by markets or government: Nonprofits may favor one particular groupover others and some groups may go without service (particularism).The interests of donors, not the needs of the community, may determinechoices nonprofits make about whom to serve and how to serve them(paternalism) Nonprofits attract well-meaning people, but either asemployees or volunteers they are often in over their heads (amateur-ism) This is known as the philanthropic failure model (Salamon 1987).Steinberg (2006) refers to this set of explanations as the Three FailuresTheory of the nonprofit sector Recent empirical research casts doubt on theunderlying assumption of Hansmann’s contract failure model Although

survey data confirm that consumers say they are more likely to trustnonprofits, the data reveal that a high proportion of consumers is unable

to identify whether well-known organizations are in fact nonprofit Evenfrontline staff working for those organizations often were unable to correctlyidentify them as nonprofit (Handy, Seto, Wakaruk, Mersey, Mejia, andCopeland 2010)

The Three Failures Theory is demand-driven There is only one side theory Young (1983) posits that certain personality types are particu-larly inclined to be nonprofit founders He shows how different typesrespond differently to the nature of a service, social priority, ethic of service,degree of professional control, income potential, bureaucratic structure, andego His supply-side model explains why there are no nonprofit automobilerepair shops, despite being a clear case of contract failure, but fixing cars isnot high on the list of priorities of people who are motivated to establish anonprofit (It should be noted that auto repair is not an exempt purpose intax law.)

supply-Nonprofits as Businesses

Although nonprofits are not in business to make money, they are less in business: They hire people, they produce goods and services, andthey have bills to pay This section explores how nonprofits are similar to,yet different from, for-profit businesses.9

neverthe-‘‘Whether an association will function satisfactorily in relation to thirdparties is to a very high degree a question of whether it becomes a [corpora-tion], i.e., a body which is regarded in law as having a personality andexistence distinct from that of its members.’’ Corporate status greatly enhan-ces the ability of an organization to own, manage, and defend property in all

of its forms (Hemstr€om, 2006, 27)

Eleemosynary organizations and membership associations pioneeredthe development of corporation law The first corporations emerged in first-century Rome (Avi-Yonah, 2005, 772) Their principal use was for municipalgovernance, guilds, religious cults, and philanthropic foundations Romansdid not use corporations for business enterprises Medieval companies ofsignificant size were quasi-permanent partnerships involving multiplepartners Precisely when the first application of the corporation to for-profitbusiness occurred is unknown; however, we do know that by the year 1283family corporations had become ‘‘common’’ in Florence (Hunt 1994, 76).These business corporations were akin to modern cooperatives becausetheir stock was not transferable

In 1650 Massachusetts awarded the first corporate charter in America toHarvard College (O’Neill 1989, 54) The first commercial corporation was

not chartered until Connecticut took the step in 1732 (Micklethwaitand Wooldridge 2003, 43) Alexis de Tocqueville’s Democracy in America,first published in 1835 and still in print, is considered one of the most in-sightful commentaries on American society Some oft-quoted phrases are:

‘‘Americans of all ages, all conditions, and all dispositions constantly formassociations Wherever at the head of some new undertaking you seegovernment in France, or a man of rank in England, in the United States youwill be sure to find an association’’ (Tocqueville 2007, 452)

His observations are often taken as ‘‘timeless truths about charity, lanthropy, and voluntarism in American life’’ (Gross 2003, 30) but it istempting to speculate that he was merely observing the consequences ofdifferences in the relative ease of forming corporations in the United Statescompared with Britain and France At the time of de Tocqueville’s visit, itrequired an act of Parliament to incorporate in Britain and incorporation didnot become common in France until the late nineteenth century

phi-‘‘By the end of the 18th century many states had general incorporationlaws for religions, academies, and libraries, but not business corporations’’(Roy 1997, 48, emphasis added) ‘‘General acts provided incorporation for abroad range of charitable, religious, and literary purposes in Pennsylvania in

1791 and for libraries in New York in 1796 and in New Jersey in 1799 Firecompanies could be chartered under general acts of Virginia of 1788 and ofKentucky of 1798’’ (Hurst 1970, 134)

What are the advantages of corporate status? All corporations are legalpersons possessing a minimal set of common attributes (Vikramaditya2005): (1) they have an indefinite life (i.e., self-perpetuating self-government),(2) they are able to sue and be sued in their own name, (3) they are able

to own property in their own name, (4) they have centralized managementempowered to act in their name (subject to laws regarding fiduciaryresponsibility), and (5) liability for the organizations’ debts is limited to theorganizations’ capital.10 Without protection from personal liability for anorganization’s debts, potential transactions costs of doing business would

be far higher and persons would understandably be reluctant to becomeactively involved

Laws typically grant all corporations considerable flexibility to governthemselves through bylaws of their own devising Business corporationscan change their line of business and nonprofit corporations can changetheir mission, provided they follow whatever process their bylaws require

As commonly perceived, the nonprofit sector consists of small tions coexisting with a few wealthy research institutes, universities, andhospitals This is true but small organizations are equally prevalent in thefor-profit sector According to Table 1.1, small organizations comprise ap-proximately one-half of the 29 million for-profit businesses and the 1.7 mil-lion tax-exempt nonprofits (including religious congregations)

Although for-profit corporations are three times more numerous thannonprofit corporations, nonprofits are more likely to be incorporated One-third of all 9 million nonprofits are incorporated compared to one-fifth of all28.7 million for-profit businesses.

Why? A large number of small businesses consist of self-employed uals whose personal finances are intertwined with their business, so incorpo-rating offers no special advantages However, nonprofit activity is inherently agroup activity, so it is important for there to be a fire wall between the finances

individ-of the group and the individuals who govern and manage it, although there

is little advantage to incorporating a nonprofit that owns no assets

The most prominent advantages of incorporation to nonprofits are:immortality, collective ownership of assets, and limited liability Immortal-ity is especially important for philanthropic projects initiated by personswho intend their perpetual continuation Because nonprofit corporationsare immortal and controlled by multiperson boards, they are indispensablevehicles for protecting capital from misappropriation by custodians andfor transmitting that capital to subsequent generations.11

There is only one difference between nonprofits and for-profitbusinesses—nonprofits are not investor-owned It might be said that they

TABLE 1.1 Nonprofit Organizations and For-Profit Businesses in 2005

Small

Nonprofits

For-Profit Businesses

For businesses, this is the number filing tax returns with the IRS (with or without reportable net income) in 2004.

report gross receipts of less than $25,000.

Sources: Bowman (2011b); Wing, Pollak, and Blackwood (2008), Tables 1.1 and 5.1 (estimates

by author based on Grønbjerg and Smith 1999); Statistical Abstract of the United States, 2008 edition, Tables 721 and 722.

own themselves The implications of this sole difference are powerful Itgives nonprofits the flexibility to decide whose interests it will serve andfor whom it will act as fiduciary [A fiduciary is an entity ‘‘who obligateshimself or herself to act on behalf of another and assumes a duty to act

in good faith and with care, candor, and loyalty in fulfilling the obligation’’(Findlaw 2011).]

Every organization is a fiduciary in some sense For-profits have a ary duty to stockholders Among nonprofits different types of nonprofitalternative income imply different fiduciary duties: Dues imply a duty tomembers, endowment income implies a duty to future generations, anddonations imply a duty to the current generation.12

fiduci-Advantages and Disadvantages of Being Nonprofit

An absence of investor-owners confers advantages on nonprofits: iveness to donors, insulated management, protected management, andendowment ownership

attract-& Attractiveness to donors Individuals are more likely to donate to anonprofit organization than to a for-profit one regardless of exemption

or deductibility of donations, especially if they perceive nonprofits to bemore trustworthy and/or public-spirited (Hansmann 1980; Valentinov2008).13Deductibility of donations merely provides further incentives

& Insulated management Some nonprofits are sponsored by anothernonprofit or by a unit of government because donors want assurancethat their gifts will not disappear into the general treasury, and bycontrolling the board donors can exert a countervailing influence topolitical processes.14

& Protected management If a for-profit publicly traded corporationperforms poorly, a group of investors may buy it Then, using theirnewly acquired power, they can replace the management team Exceptfor membership associations with elected leaders, only state attorneysgeneral may sue to remove management, which occurs rarely (Fremont-Smith 2004)

& Endowment ownership An endowment is a portfolio of investmentsmanaged so as to produce a perpetual source of income to subsidizegoods and services below their cost of production indefinitely If a for-profit firm produced a product that cost more to produce than it earned,the firm would drop it, not endow it If it did attempt to endow it, agroup of investors would surely emerge to take control of the organiza-tion and its endowment Protected management enables nonprofits toown endowments

The foregoing discussion focused on intrinsic differences between profits and for-profits due to the absence of investor-owners However, pub-lic policy also favors nonprofits Heading the list of these advantages is taxexemption.

non-Despite popular perceptions, nonprofit status and tax exemptionare not congruent In Indiana, for example, the number of nonprofitsrecognized by the IRS approximately equals the number not recog-nized (Grønbjerg, Liu, and Pollak 2010) (Technically, the IRS does notconfer exemption; it recognizes an organization as being exempt.)Charitable nonprofits further benefit from deductibility of contributions

by donors

Bankruptcy laws are more favorable: A nonprofit’s creditors cannotforce it to involuntarily liquidate, and when nonprofits choose to reorganize

in Chapter 11 they remain debtors in possession.15

Unlike publicly traded companies, the law does not require nonprofits

to have an annual meeting open to the public or to have their financial ments audited The most recent federal law on corporate accountability(Sarbanes-Oxley) exempted nonprofits from all but two provisions TheU.S Supreme Court has made it clear in a series of decisions that state andlocal laws cannot compel nonprofits to disclose their fund-raising andadministrative costs to prospective donors.16

state-The only information available to the public about tax-exempt its is from an informational return they are required to file annually with theIRS (see Chapter 5); but one-quarter of nonprofits with at least $500,000 indonations reported no fund-raising expenses, and a significant number ofForm 990 reports allegedly contain material omissions, misrepresentations,

nonprof-or falsifications (Hall 2000)

These advantages, taken together, enable nonprofits to behave ferently Their business is promoting values and even in industries with thegreatest dependence on commercial income they act differently To someobservers, nonprofit hospitals are ‘‘large and highly commercial’’ enterprisesthat ‘‘do not look, feel, or act very much like the mental images that most of

dif-us have of nonprofit organizations’’ (Hodgkinson and Weitzman 2001, 5).Schlesinger and Gray (2006, Table 16.1) reviewed all peer-reviewed re-search on the topic and found that in 114 comparative hospital studies, non-profits performed better in terms of economic performance (21 studies),quality of care (14 studies), and accessibility for unprofitable patients(28 studies) Only 11 of these studies found that proprietary hospitals per-formed better on these same criteria Furthermore, in 68 empirical studies ofnursing homes, for-profit homes had better economic performance (19 com-pared to 5) but nonprofit nursing homes unambiguously performed better interms of quality and accessibility (26 compared to 6) However, there areseveral disadvantages of being nonprofit

& Mission constraint State laws typically restrict the purposes that theyallow nonprofits to undertake, and tax laws discourage others (seeChapter 5) However, arguably these limitations and disincentives

do not affect the outcome much To repeat an earlier example:Although auto repair may not be a permitted purpose for incorpora-tion and is not an exempt purpose for relief from taxation, there areprobably few people who want to do it anyway

& Capital constraint This may be the most important disadvantage.Although nonprofits receive gifts of capital, these are not free Fund-raising costs may be substantial In addition, the pool of major donors islimited for nonprofits, whereas the pool of capital available to for-profits

is virtually unlimited and truly global When a for-profit has aninitial public offering (IPO), its stock sells out in a day Although theinvestment banker is well compensated, the amount of money raisedrelative to issuance expenses is small compared to fundraising(Bowman 2011a)

& Mission drift and waste Although having no investor-owners vides space for amateurs to learn on the job and make mistakes,this advantage comes with an increased prospect of mission driftand wasteful management (See the opening vignette of Chapter11.) If a for-profit company is not doing a good job of looking outfor its investor-owners’ interests, one or more of them can make atender offer to buy a controlling share and replace ineffectual man-agement There is no mechanism for replacing derelict directorsand officers of nonprofits other than a state attorney general filing

pro-a lpro-awsuit

& Risk In for-profit corporations stockholders share business risks.Individually they can mitigate their risk exposure by selling thecompany’s stock (if they shun risk) or buying more (if they like risk).Because nonprofits have no stockholders, their clientele absorbs theentire risk alone and, unlike a for-profit’s stockholders, clients of non-profits have no way to mitigate risk Nonprofit directors and officersmust be more sensitive to the risk associated with various revenuesources and services offered, particularly new ones with unknownrisk characteristics

Table 1.2 summarizes the advantages and disadvantages of being profit For some activities, like producing microwave ovens, the disadvan-tages outweigh the advantages For other activities, like disaster relief, theadvantages outweigh the disadvantages

non-From society’s point of view, the advantages of a robust nonprofitsector outweigh the disadvantages Nonprofits provide ‘‘a large variety

of partially tested social innovations,’’ which Smith (1973) calls ‘‘social

risk capital.’’ They create intellectual space for ‘‘countervailing gies, perspectives, and worldviews’’; searching for ‘‘novelty and beauty’’;providing ‘‘fellowship, sociability, and mutual companionship’’; preserv-ing ‘‘values, ways of life, ideas, beliefs, artifacts’’; representing the sense

ideolo-of ‘‘mystery, wonder, and the sacred’’; and ideolo-offering ‘‘unique ties for personal growth.’’

opportuni-Nonprofits are custodians of society’s values, and the most prominentvalues-driven organizations are affiliated with religious congregations

‘‘Universally, religious groups are the major founders of nonprofit serviceinstitutions We see this in the origins of many private schools and voluntaryhospitals, in the U.S and in England, Catholic schools in France and Austria,missionary activities in developing countries, services provided by Muslimwacfs [religious trusts], and so on’’ (James 1987, 404)

This Book’s Agenda

Both for-profit businesses and nonprofits must pay their bills Whenresources are chronically inadequate, liquidation is inevitable for both Asthe saying goes, ‘‘no money, no mission.’’ However, nonprofit accountingrules are different, which has consequences for budgeting Endowed non-profits have additional legal constraints that affect their financial operations

TABLE 1.2 Advantages and Disadvantages of Nonprofit Status and Tax Exemption

Capital available

No donationsManagers neither

Never endowed

No purposerestrictions

Tax-exempt nonprofits are likely to be less capital constrained and receive more donations and endowment-building gifts than if they are taxable.

The next four chapters take a fresh look at common financial tools—financial statements, investment portfolios, and budgets—and tax lawrelevant to different types of nonprofits.

Chapter 2 reviews accrual accounting, highlighting treatment ofnoncommercial (alternative) income

Chapter 3 covers legal and management issues an endowment raises Itdescribes the Uniform Prudent Management of Institutional Funds Act,which nearly every state has adopted in some form

Chapter 4 explains how to configure budgets to be consistent withnonprofit accounting rules and how to reconcile a budget with a financialstatement and IRS Form 990

Chapter 5 describes how federal tax law classifies tax-exempt tions and how this is similar to, yet different from, the archetypical non-profits that define the themes of the following chapters This chapterintroduces each archetype with a brief history of important events in itsevolution in the United States

institu-Each of the next four chapters focuses on a specific archetype, which isdefined by the group of persons to whom a nonprofit organization owes afiduciary duty, because it is reasonable to suppose that different responsibil-ities influence the range of normal financial behavior

All archetypes are analyzed within a similar tripartite temporalframework: (1) in the long run the objective is to maintain or expand ser-vices, (2) in the short run the objective is resilience to occasional economicshocks, and (3) in the current period the objective is to pay bills on time.Chapter 6 focuses on ordinary service providers These nonprofits have

a fiduciary duty to act in the best interests of one or more indefinitegroups of living persons (Bowman and Fremont-Smith 2006) Indefinitemeans that members of the relevant group cannot be identified byname—only by common characteristics such as income, age, culture,and interests The modifier ordinary indicates that they do not haveendowments It may seem a mundane descriptor but it serves to indicatethat they are the most common type

Chapter 7 features membership associations Membership associationshave a duty to act in the best interests of a specific group of living persons,

or other organizations, called members or patrons, who are usually able toparticipate in election of decision makers for the group Dues are a financingsource that is unavailable to providers of goods and services, and thereforethese nonprofits need different benchmarks.17 As indicated previously,cooperatives are difficult to classify Chapter 7 treats them as membershiporganizations while indicating how they differ from noncooperativeassociations

Chapter 8 is about endowed service providers A growing body of ture calls attention to the importance of endowments and their unique

management issues (Ehrenberg 2000; Gentry 2002; Fisman and Hubbard2003; Bowman 2002b, 2007; Weisbrod, Ballou, and Asch 2008; Lerner,Schoar, and Wang 2008) These organizations, like ordinary service provid-ers, have a duty to an indefinite group within the current generation but theyalso have a duty to future generations The large investments of these orga-nizations require modification of the diagnostic formulas for capacity andsustainability.

Chapter 9 highlights grantmakers These organizations are agents ofdonors with a duty to act as the donors would under similar circumstances.There are three kinds of grantmakers: conduit, limited life, and endowed.Conduit grantmakers pass through current income from donors to service-providing nonprofits Limited life grantmakers are established with theintention that they will spend themselves out of existence within a finiteperiod of time Endowed grantmakers serve future generations

Table 1.3 summarizes the characteristics of these archetypes, showinghow organizations are classified according to the nature of their fiduciaryduty to present and future generations

Chapter 10 explains how the types of goods and services producedaffect the composition of revenues and describes how producers of goodsand services can improve sustainability through revenue management.Chapter 11 describes ethical duties of nonprofit organizations andapplies the lessons of previous chapters to exploring the use and misuse

of business principles by nonprofits

TABLE 1.3 Nonprofit Archetypes

Generation Served

Note: Membership associations include cooperatives; other grantmakers include limited life and conduit grantmakers.

Concluding Thoughts

Returning to the questions that opened this chapter, what are we to make ofthe New York Stock Exchange operating as a nonprofit for nearly 200 years,for-profit charities like Google.org, and for-profit companies operating asnonprofits, like IKEA?

Until 2006 the New York Stock Exchange was a comfortable nonprofitmembership association Until recently it was competitive with otherexchanges around the world Then the market changed and it needed sub-stantial fresh capital quickly to retool its operations and to combine with in-vestor-owned exchanges It had literally outgrown its nonprofit charter.Google attempted to overcome the nonprofit capital constraint by usingits ability to sell stock to finance an ancillary social mission Its goal wasnothing less than reinventing philanthropy, but it has yet to find a newworkable model (Helft 2011) To an outside observer, DotOrg (as companyinsiders call the philanthropic division) appears to operate more like a ven-ture capital firm with a social agenda It is a novel and useful paradigm, even

if it has not inspired other corporations to follow suit

IKEA has enjoyed a near-monopoly in the do-it-yourself furniture ket, so it has not needed external sources of capital to grow The nonprofitarrangement has served its founder well by allowing him to remain firmly incontrol for decades It remains to be seen how well the arrangement willserve the organization after he is no longer at its helm, especially if andwhen a rival company finally emerges to challenge its supremacy in its mar-ket niche

mar-It is interesting to note that IKEA has established what amounts to anendowment with retained earnings However, its purpose is not to subsidizeproducts below their cost of production as nonprofit endowments do but to

be a pool of capital-in-waiting for establishing new stores The definitivestudy of IKEA has yet to be written, but a probable consequence of self-financing is slower growth, which it accepted as the trade-off for tight con-trol over all aspects of operations

Each of these examples, odd as they seem at first sight, illustrates theadvantages and disadvantages of being a nonprofit organization Experimen-tation with hybrid organizations can be interpreted as efforts to combinethe advantages of both pure types (nonprofit and for-profit), meanwhilediminishing their disadvantages

CHAPTER 2

Accounting

Measuring Past Performance

A well-respected and apparently successful organization suddenly went out

of business The last board chair alleged that accounting rules had obscuredwhat was happening, but it would be more accurate to say that the boarddid not understand the rules This chapter develops the vocabulary and con-cepts necessary to discuss finance and to identify life-threatening problemslike the one this hapless organization experienced The concluding sectionexplains how the organization imploded

For-profit accounting is designed to monitor exchange transactions inwhich one party gives goods and services to another party in return forsomething of economic value Not-for-profit accounting is more compli-cated because it must also be able to monitor transactions where one partygives something of value to another party, receiving nothing of economicvalue in return—in other words, voluntary contributions Furthermore, not-for-profit accounting must also deal with the vexing problem of valuation ofmuseum collections and historical sites

Accounting professionals prefer the term not-for-profit to the more monly used synonym nonprofit This chapter employs the profession’sfavored term but elsewhere this book uses the common term.1It is orga-nized into sections corresponding to different statements (tables) found in acomplete set of financial statements, with a section showing how to recon-cile financial statements with the IRS Form 990 informational return Datafrom a pseudonymous university will illustrate the concepts

com-The sections on statement of financial position, statement of activities,and statement of cash flows include background material for accountingnovices (Note to novices: A negative number is enclosed in parentheses.)

15

Finance Fundamentals for Nonprofits: Building Capacity and Sustainability

by Woods BowmanCopyright © 2011 Woods Bowman

In these sections, readers who are already familiar with accounting can skip

to subsections headed ‘‘The Not-for-Profit Difference.’’ Following these tions is a discussion of what to look for when encountering a particular set

sec-of financial statements for the first time and an explanation sec-of the ship between information on financial statements and information on theIRS Form 990

relation-Basis of Accounting and Audits

There are two bases of accounting: cash and accrual Cash accounting cords transactions that increase or decrease an organization’s cash balance.Roughly half of all 501(c)(3) public organizations use cash accounting.2However, cash accounting gives an incomplete picture of an organization’sfinancial position For example, it does not reveal when unpaid bills are pil-ing up Nevertheless, small not-for-profits like it because households use itand untrained bookkeepers are comfortable with it

re-Accrual accounting recognizes (records) a transaction when an gation to pay or be paid arises It recognizes a purchase of services as

obli-an expense whether it is settled in cash or obli-an invoice is left to lobli-anguish

on a desk unpaid Generally accepted accounting principles (GAAP) quire the accrual basis of accounting In the absence of state law requir-ing audited financial statements, not-for-profits have the option to usecash or accrual accounting.3 However, stakeholders (grantors, bankers,and major donors) may ask to see financial statements prepared accord-ing to GAAP

re-GAAP for not-for-profits is promulgated by the Financial AccountingStandards Board (FASB) through Statements of Financial Accounting Stan-dards (SFAS) and supplemented with published interpretations and opin-ions The most significant statements pertaining to not-for-profits are SFAS

116, Accounting for Contributions Received and Contributions Made (FASB1993a) and SFAS 117, Financial Statements of Not-for-Profit Organizations(FASB 1993b).4

There are five not-for-profit general-purpose financial statements plusnotes prepared according to SFAS 117:

1 Statement of financial position (required for all)

2 Statement of activities (required for all)

3 Statement of cash flows (required for all)

4 Statement of functional expenses (required for voluntary health andwelfare organizations only)

5 Statement of changes in net assets (optional)

6 Notes to the statements (required for all)

Audits also adhere to SFAS 117 Information in the notes is audited aswell Audits are conducted in accordance with auditing standards generallyaccepted in the United States (the Yellow Book), which require auditors to

‘‘obtain reasonable assurance about whether the financial statements arefree of material misstatement.’’

Audited statements begin with a report of the independent auditor—sometimes called the audit letter or opinion letter The date on this letterindicates the date the auditor completed fieldwork A common mis-perception is that auditors prepare the statements Opinion letters clearlystate, ‘‘These financial statements are the responsibility of management Ourresponsibility is to express an opinion on these financial statements based

on our audit.’’ The auditor’s job is to opine on the quality of the informationand not to analyze it

An unqualified (clean) audit opinion will include the phrase: ‘‘In ouropinion, the financial statements present fairly in all material respects .’’This implies that any remaining errors are likely to be ‘‘immaterial’’—that is,they would not affect a considered judgment about the financial condition

of the organization If the auditors discover material weaknesses, theirreport will include the phrase ‘‘except for ’’ and identify the materialweaknesses, followed by ‘‘the financial statements present fairly in all mate-rial respects .’’

In addition to their report, which is part of the audit document,auditors usually provide management with a list of reportable condi-tions, which are weaknesses in financial policies and procedures that donot rise to the level of a material weakness This is called the ‘‘manage-ment letter,’’ and it is not part of the audit document It is a helpful roadmap for self-improvement

Statement of Financial Position

A statement of financial position is an inventory of assets and liabilitiestaken at a particular moment, usually at the end of a fiscal year It is com-monly referred to as the balance sheet, as in a for-profit business It is like aphotograph of an organization’s finances because it captures the situation at

a single moment

Assets are everything of value an organization owns, including tions of other parties to pay the organization Value in this context refers tomarket value and/or commercial (income-producing) value

obliga-A statement of financial position is often presented in columnar formatlisting assets first, in decreasing order of the ease with which they can beconverted into cash (liquidity) Current assets, which are likely to convertinto cash within one year, head the list

How an asset is valued depends on the type of asset Marketable ties are valued at their market value Property, plant, and equipment (PP&E)are valued at original cost minus accumulated depreciation PP&E corre-sponds to land, buildings, and equipment (LB&E) on the IRS Form 990.5Depreciation is ‘‘the cost of using up the future economic benefits orservice potentials of long-lived tangible assets’’ in a given year (FASB 1987a,para 3); it is a calculated, not measured, quantity Accumulated depreciation

securi-of an asset is the sum securi-of all depreciation from the date securi-of acquisition to thepresent (Note: Land does not depreciate.) The section on the statement ofactivities discusses depreciation further

In a columnar format, liabilities follow assets Liabilities are the value ofall obligations an organization owes to other parties Current liabilities,which are debts that will be coming due within a year, head the list.Noncurrent debt, such as mortgages, bonds, and postretirement employeebenefits, are at the bottom of the liabilities list Sometimes the currentportion of a mortgage or bond issue is reported in a separate category underthe heading noncurrent liabilities This is the amount due with the nextfiscal year For analytical purposes, it should be added to current liabilities.The last items on a statement of financial position are net assets, the not-for-profit analogue of net worth or owners’ equity in a for-profit business.Net assets equal total assets minus total liabilities

The Not-for-Profit Difference

If a donor makes a gift for a specific purpose or for use at a specific time, theasset is said to be restricted.6If a donor does not explicitly restrict a gift with

a written gift agreement approved by the recipient, it is unrestricted and therecipient may use it for any purpose—even if the gift was made in response

to a plea for a particular purpose Property, plant, and equipment are restricted by definition

un-Not-for-profits must classify their net assets by type of restriction.7Restrictions may be permanent or temporary

& Permanent restrictions never expire and there is nothing an tion can do legally, short of getting court approval, to apply a perma-nently restricted gift to a different purpose

organiza-& Temporary restrictions may expire after a donor-specified period oftime (time-restricted) or after the donor-specified purpose hasbeen achieved (purpose-restricted) Pledges without donor-imposed re-strictions are nevertheless classified as temporarily restricted until theyare fulfilled—that is, when the organization receives the promised gift

If net assets are not classified, they are presumed unrestricted:Unrestricted net assets equals Assets minus Liabilities minus Restricted net

assets The only way for restricted net assets to decrease is to satisfy donorrestrictions Spending restricted net assets for purposes not authorized by adonor causes a decrease in cash (or investments) and unrestricted net assetsbut not a decrease in restricted net assets.

A board may designate some or all unrestricted net assets for specificfuture purposes In this case, the statement of financial position will showthe amount designated by purpose Unlike restrictions, which are binding,designations are not binding, because a board may reverse itself and elimi-nate a designated account at will

Table 2.1 is a simplified version of a real, but pseudonymous, sity’s statement of financial position This is a typical presentation

univer-Cash reflects currency and deposits or other accounts with financialinstitutions that may be deposited or withdrawn without restriction orpenalty

Cash equivalents represent short-term and highly liquid investmentsthat convert readily to cash and carry little risk of change in value at maturity

TABLE 2.1 Statement of Financial Position of Famous University, 2007 ($1,000s)

due to interest rate changes (The next chapter on investing definesthese terms.)

Accounts receivable and accounts payable refer respectively to tions other parties have to pay the university within a year for services itrendered to them and obligations the university has to pay other partieswithin a year for services they rendered to it

obliga-The next section explains deferred revenue

A not-for-profit organization with custody of important artifacts, like amuseum or historical site, may elect one of the following options: (1) notreport the value of the collection, (2) report only the value of additions tothe collection occurring after the adoption of SFAS 116, or (3) report thevalue of the collection on the financial statements (Ruppel 2007, 143) Theseassets may or may not be depreciated.8

The true value of a cultural asset, however, ‘‘is not determined through anet present value calculation of future cash flow it can generate; rather it isdetermined by the relevance of that asset to the broader cultural purposesand capacities of the institution to which it belongs’’ (Guthrie 1996, 153; seethe Glossary for description of present value)

Statement of Activities

A statement of activities summarizes revenues and expenses occurring ing a given time period—usually one year Revenues increase net assetsand expenses decrease them, so the former minus the latter is the change innet assets Thus, a statement of activities reveals how net assets on a state-ment of financial position evolved from net assets on the previous one Ifthe statement of financial position is analogous to a photograph of anorganization’s finances, a statement of activities is analogous to a videoshowing how one photo relates to the previous one

dur-A statement of activities can be arranged in a single column or parallelcolumns, with one column for each type of restriction plus one for the total.Famous University uses a columnar format It has a mixed revenue streamconsisting of contributions, investment income, and program servicerevenue.9

Revenue is recognized (recorded) when it is measurable and earned.10GAAP recognizes some transactions as creating revenue because theyincrease net assets while providing no immediate cash for spending:

& When the market value of investments increase The amount of increase

is called unrealized capital gains (colloquially, paper gains) oninvestments

However, cash received is not always revenue, because it does not crease net assets:

in-& When an organization borrows (there is an offsetting liability)

& When cash is received in advance of its being earned (called an advance

or deferred revenue)

The last point requires explanation When an organization receivespayment before performing a service, it is not revenue but it increases itscash assets The organization records an equal liability called an advance

or deferred revenue, which cancels the impact of increased cash on netassets As the service is rendered, the liability is removed and the revenue

is recognized

To illustrate: Assume that a not-for-profit theater sells season tions for a series of five plays in a cash-only transaction Before the seasonbegins, none of the cash can be recognized as revenue because the theater

subscrip-TABLE 2.2 Statement of Activities, Famous University, 2007 ($1,000s)

Excess (deficiency) of operating revenues

A

Note: Letters A, B, and C are labels referred to in the text.

with the donor’s restrictions.

has not yet earned it Subscription sales go on the statement of financial sition as cash, and the theater’s accountants balance it by creating an equalamount of deferred revenue as an offsetting liability Since net assets do notchange, there is no revenue recognized at this time It should be easy to seewhy cash received before being earned is a liability: If the theater cancels theseason, it must refund the cash to its patrons After each performance,deferred revenue is reduced by one-fifth, which increases net assets, causingrecognition of one-fifth of the cash as revenue.

po-An expense is recognized when it is measurable and incurred, which plies an obligation to pay Therefore, the following are not expenses:

im-& Spending to acquire property, plant, and equipment

& Repayment of principal of borrowed funds (interest paid, however, is anexpense)

& Payments to vendors in advance of receiving goods or services (prepaidexpenses)

None of these examples are expenses because net assets do not change

In the first example, an asset replaces the cash used to buy it and theexchange cancels out on a statement of financial position In the secondexample, repayment of debt reduces cash in the bank but also reduces liabil-ities (debt) by an equal amount These changes cancel each other, leaving

no impact on net assets, hence no expense is recognized The last tion is more complicated This anticipatory transaction creates an equal pre-paid expense asset on the organization’s statement of financial position thatreplaces the cash, which is now in the vendor’s hands Upon receipt ofgoods and services, the organization removes the prepaid expense from itsstatement of financial position and records the amount as a real expense,which then decreases net assets

transac-Instead of recognizing the purchase of a building as an expense atthe time of purchase, GAAP requires that the original cost be dividedinto pieces, with one piece being recognized as an expense in each year

of its useful life This is called depreciating an asset, and the annual rement is called depreciation, which is classified as an expense Mostnot-for-profits use the straight-line method of depreciation, whichspreads the purchase price of a capital asset over its useful life in equalannual installments.11

dec-The Not-for-Profit Difference

Not-for-profit revenue may include voluntary contributions tions, also called public support on financial statements, are recognizedwhen made

A contribution is ‘‘an unconditional transfer of cash or other assets to anentity or a settlement or cancellation of its liabilities in a voluntary non-reciprocal transfer by another entity acting other than as an owner’’ (FASB1993a, para 5) On a statement of activities, contributions are sometimescalled public support.

Tax-deductibility requires that a contribution be ‘‘an irrevocabletransfer of property or cash from a qualified donor to a qualified donee[recipient] for less than full consideration’’ (Bryce 2000, 179) Further-more, the donor must retain no rights in the property, exert no controlover it, and receive no benefit from it Pledges are usually reported net

of an allowance for uncollectable amounts Sometimes the balance sheetshows the allowance explicitly Either way, an increase in the allowance

is equivalent to an expense

For simplicity, this book classifies contributions with revenue GAAPrecognizes some transactions as creating revenue because they increase netassets although they provide no immediate cash:

& Donated goods, known as noncash contributions, or gifts in kind

& Promises to give (pledges), but only when a donor makes the pledge inwriting and the recipient verifies acceptance (FASB 1993a, para 6).However, cash received is not always revenue, because it does not in-crease net assets:

& When a donor fulfills a pledge by writing a check because it had alreadybeen recognized when pledged

Other not-for-profit revenue is classified as restricted or unrestrictedsubject to the following rules:

& The portion of a multiyear grant eligible to be spent in the first year isunrestricted provided it is used for its intended purpose The portionearmarked for subsequent years is temporarily restricted It will bereclassified to the unrestricted category in the year it is eligible to

be spent In the meantime, it is recognized at its present value (See theGlossary for a description of present value.)

& Program service revenue is unrestricted by definition

& Donated goods and services (known as noncash or in-kind) areunrestricted and recorded at current market value

Expenses are unrestricted by definition

GAAP allows reporting the value of volunteers’ time only if: (1) the time

is spent building an asset for the not-for-profit or the volunteer possesses a

professional skill, such as an attorney or a certified public accountant (CPA),and (2) the not-for-profit would have paid for the service had it not beendonated Donated volunteer time is recorded twice—once as revenue andonce as an equal expense, because the services would have been purchased

if not provided by volunteers

A not-for-profit need not recognize works of art, historical treasures,and similar assets if the donated items are added to collections that meet all

of the following conditions:

(1) [They] are held for public exhibition, education, or research in therance of public service rather than financial gain; (2) [they] are pro-tected, kept unencumbered, cared for, and preserved; or (3) [they] aresubject to an organizational policy that requires the proceeds from sales

fur-of collection items to be used to acquire other items for collections (FASB1993a, para 11)

Net assets released from restrictions consist of prior-year gifts and grantsthat are legally available for spending in the current year.12 The total ofunrestricted revenue and net assets released from restrictions represents cur-rent resources available for spending Reclassification of net assets does notincrease the total; hence it is not revenue Rather, it makes revenue that wasrecognized in an earlier period available for spending in the current period.Net assets released from restrictions are unrestricted by definition

Statement of Cash Flows

‘‘Cash is king,’’ as the saying goes Many transactions generate cash that isnot revenue and many use cash that is not an expense But all organizationsneed cash to operate So it is important to keep track of which activitiesprovide cash and which ones use it

The statement of cash flows reconciles changes in cash and cash alents with changes cash between consecutive statements of financial posi-tion If operating surpluses seem adequate but cash is short, a review of thestatement of cash flows can help identify the problem

equiv-GAAP permits a statement of cash flows to be presented according toone of two formats The more common indirect method is described here Astatement of cash flows by the indirect method is arranged in a column.Changes in cash in Table 2.3 may be due to (1) financing, line F, (2) in-vesting, line E, and (3) operations, line D, defined as follows:

Financing activities include borrowing money and repayingamounts borrowed, or otherwise settling the obligation; and obtainingand paying for other resources obtained from creditors on long-termcredit (FASB 1987b, para 8)

Investing activities include making and collecting loans and acquiringand disposing of debt or equity instruments and property, plant, andequipment (FASB 1987b, para 7)

Operating activities fall into neither of these categories They generallyinvolve producing and delivering goods and providing services (FASB1987b, para 8)

In the following formula,D indicates a change in an item on a statement

of financial position during the reporting period.13A positive change in net

TABLE 2.3 Cash Flow of Famous University 2007, Presented in Indirect Format($1,000s)

Adjustments to Reconcile Change in Net Assets

to Net Cash Provided by Operations

Private gifts and grants for buildings

Private gifts and grants for buildings and

Note: Shaded area is change in working cash, which is discussed in the next chapter.

because it is long-term Operations by definition are short-term.

assets or liabilities, or a negative change in assets (other than cash), indicatesthat a change increased the organization’s cash balance, providing it withcash The reverse implies it used cash, and is indicated by parentheses.

 D Long-term assets ðinvestingÞ

þ D Long-term liabilities ðfinancingÞ

The boldface items are ‘‘net cash provided (used) by operations,’’ a tion of the statement of particular importance because it shows how anorganization’s working capital changed during the year (The next chapter

sec-on investing discusses working capital.) The relevant items are shaded

on Table 2.3 The statement of cash flows does not distinguish betweenrestricted and unrestricted amounts Line G in Table 2.3 equals the change

in cash between 2006 and 2007 on Table 2.1

Other Statements and Notes

Other GAAP statements are the statement of functional expenses and ment of changes in net assets These statements are uniquely not-for-profit.GAAP requires a statement of functional expenses only for health and welfareorganizations A statement of changes in net assets is optional and rarely used.Statement of Functional Expenses

state-The statement of functional expenses, required for health and welfare nizations, is a table showing the breakdown of expenses on a matrix:(1) functional expenses, which are classified on the IRS Form 990 form asadministrative, fund-raising, and program expenses, and (2) natural catego-ries, also known as budget line items

orga-When reading a 990 informational return, one must exercise caution Anational survey of 1,500 not-for-profits with at least $50,000 in contributionsrevealed that over one-third reported zero fund-raising expenses and 13 per-cent of not-for-profits report zero management and general expenses(Wing et al 2006) Proper expense allocation requires maintaining records

of staff time utilization, but only one-third of not-for-profits track staff time

by functional expense category

The same survey disclosed that only 25 percent of not-for-profitsreceiving foundation grants and 17 percent of not-for-profits receiving

government grants properly classify proposal-writing costs Foundationgrants are equivalent to contributions, so proposal-writing costs should

be treated as a fund-raising expense When a grant involves an exchangetransaction with a government agency, proposal-writing costs should

be classified as administrative expenses

Because budgets and accounting systems typically keep track of ing by natural categories, this breakdown is probably more reliable

spend-Statement of Changes in Net Assets

This statement shows balances in each category of net assets and showsreclassifications It also shows board-designated funds and transfers into,out of, and between them Although it provides backup for arguments

in favor of having substantial net assets, few not-for-profits include thisoptional statement

Notes to Financial Statements

On each page of tables is a phrase referring readers to accompanying notes.They are an integral part of the statement, and the information they contain

is included in an audit

Notes contain a wealth of information The first note always describesthe organization and significant accounting policies Other notes to givedetails about investments, capital leases, and debt obligations, which arevery helpful in assessing an organization’s long-term financial prospects

‘‘Subsequent events’’ and ‘‘contingent liabilities,’’ if any, are usuallyfound at the end of the notes section Subsequent events are events thatoccurred after the fieldwork was done

What to Look For

Chapters 6 though 9 explain how to use financial statements to analyze anorganization’s financial capacity and financial sustainability, but it is helpful

to know what to look for to get a quick first impression Here is a short list,roughly in order of examination:

1 The auditor’s opinion

2 The first and last notes

3 Unrestricted net assets

4 Change in unrestricted net assets, or if the organization has considerableinvestments

4b Operating revenues minus operating expenses.

5 Cash produced by (used in) operations

It is obvious where to find the first two items Item three is found on thestatement of financial position, items four and five are on the statement ofactivities, and item six is on the statement of cash flows All of the statementsand notes are necessary for a complete picture, even a once-over-lightly firstimpression

The first thing to discover is whether the information in the financialstatements is reasonably free of material misstatement and, if not, what theweaknesses are The first note describes the organization and its accountingpolicies Combined with the opinion letter, this information tells a readerhow to interpret the numbers

The end of the notes section is information on subsequent events, if any,that might have a material impact on the organization’s finances butoccurred too late to be incorporated into the statements Also at the end ofthe notes section is information on contingent liabilities, if any, such aspending lawsuits that could result in a major judgment against theorganization

Solvency

Solvency refers to the ability of an organization to remain in business (to be agoing concern) while continuously satisfying all ongoing financial obliga-tions in a timely manner The complementary concept, insolvency, is predic-tive of an organization’s demise at the hands of its creditors There are threekinds of insolvency: (1) balance sheet insolvency, or insolvency in liquida-tion, (2) cash flow insolvency, or operational insolvency, and (3) capitalinadequacy (Heaton 2007) This subsection discusses the first type ofsolvency; the next two subsections take up the others in turn

A for-profit business is balance sheet insolvent if its net assets are lessthan zero Upon liquidation, such an organization would be unable todischarge all existing obligations to creditors A not-for-profit is balance-sheet insolvent if its unrestricted net assets is negative It will be unable

to fulfill commitments made to donors of restricted grants as well as itscreditors Famous University had over $6 billion in unrestricted net assets

in 2007, so it is very solvent in this sense This is typical of endowed for-profits

not-The Bottom Line

The key summary figure of a statement of activities is the so-called bottomline For a for-profit business it is profit (earnings), which is revenue minus

expenses, but all revenue of a for-profit firm is unrestricted and investmentrevenue is usually a minor factor (except for financial institutions).

Because not-for-profits may have restricted revenue, GAAP requiresreporting of two bottom lines, which differ as a consequence of donorrestrictions:

1 Change in total net assets (total surplus) equals total revenue minus totalexpenses (line C, Table 2.1)

2 Change in unrestricted net assets (unrestricted surplus) equals restricted revenue minus total expenses (line B, Table 2.1)

un-If an organization has no investments and no restricted gifts, these iants of the bottom line are equal

var-GAAP does not use the word surplus, but it is commonly used by for-profits and it simplifies exposition A negative surplus is called a deficit.Some authorities refer to negative net assets as a deficit, but it is more accu-rate to say that negative net assets are an accumulated deficit

not-Although deficits frequently produce cash shortages, surpluses do notnecessarily result in larger cash balances Repeated operating deficits on thestatement of activities will eventually impair an organization’s ability to payits bills on time, although it could continue operating as long as it is able tosell off its assets to generate cash If an organization is balance sheet solventbut it cannot pay its bills when due, it is cash flow insolvent (or operationallyinsolvent)

All endowed not-profits, such as Famous University, and some profit businesses focus on a third bottom line, operating surplus GAAPgives organizations latitude to define it as it best describes their situation.Generically:

for-& Operating surplus equals operating revenue minus operating expenses(line A, Table 2.1)

Because GAAP does not define it, one may observe differences indefinition and captioning between statements If an organization hasrestricted revenue but no investments, then unrestricted surplus andoperating surplus are equal Further discussion of operating surplus isdeferred until Chapter 3

Capital Inadequacy

There is no precise definition of the third type of insolvency—capital adequacy However, it is worth mentioning because it has been implicated

in some bankruptcy cases (Heaton 2007) It occurs when assets barelyexceed liabilities and the organization has been paying its bills but almostalways late.

Capital inadequacy comes into play when an organization is solvent onthe first two criteria but everyone knows that it is struggling and some havegiven up on it As a rule of thumb, when an organization’s net assets are lessthan 10 percent of total assets, its statement of cash flows should be exam-ined with special care

If an organization has been using cash in operations over a period ofyears, then the conclusion follows that it has been able to stay solventaccording to the first two criteria by selling its assets If it has very little capi-tal remaining, liquidation is inevitable This is capital inadequacy insolvency.The statement of cash flows shows exactly how an organization israising cash In Table 2.3 this appears on the line ‘‘Net cash provided

by (used in) operations.’’ Famous University’s operations produced

$187 million in 2007, so it is solvent by this test as well

IRS Form 990

Audited financial statements is the preferable source of financial information

on a not-for-profit organization However, in some cases an analyst has cess only to IRS Form 990 reports (GuideStar 2010)

ac-At first glance, an IRS Form 990 informational return appears to providethe same financial data as an audited financial statement provides, but thereare four important differences (See Chapter 5 for a discussion of filingrequirements.)

1 Revenue is not disaggregated by type of donor restriction

2 Form 990 does not show the increase in market value of investments,which financial statements consider as revenue

3 Form 990 shows cash (non-interest-bearing) and savings bearing) but there is no ‘‘savings’’ line on financial statements Instead,financial statements divide interest-bearing investments between cashequivalents and investments There are other differences, but fortu-nately the section of the IRS Form 990 immediately following the finan-cial position section contains information on items that are included

(interest-in one but excluded from the other

4 There is nothing on an IRS Form 990 that corresponds to a statement ofcash flows For simple organizations without investments, it might

be possible to construct one as described in this chapter but not forendowed organizations